F5 Networks reported strong fiscal third-quarter results, with the top line coming in at the upper-end of management guidance and margins widening slightly. The products segment delivered year-over-year growth for the first time in four quarters, driven by continued strength in their software solutions for public and private cloud infrastructure, as well as their standalone cybersecurity products. This growth was offset by continued softness in the systems business. Services, which we view as the main growth driver in a normalized environment, continued its momentum in the quarter. We are maintaining our narrow moat rating and $126 per share fair value estimate for this name. As the architecture of IT infrastructure continues to shift, we believe well-capitalized cloud providers likely will take share from F5 in their traditional areas of dominance. Additionally, we do not view F5 as competitively advantaged in the cybersecurity business, and given the intense competitiveness of this space, we don't see their progress here as accretive to margins. Consequently, we are also maintaining our negative moat trend rating. The shares dipped 3% in after-hours trading but remain significantly overvalued at current levels.
Revenue of $542 million represented a 4.7% increase year over year. Software remained stable as a proportion of product sales at 15%, and its 24% year-over-year increase, offset by a 1.5% decline in the much larger systems business, drove a 1.6% top-line increase in the products segment. Services revenue continued to impress, increasing by 7% in the quarter over the prior year. GAAP operating margin expanded by 110 basis points to 28%. We attribute this expansion to operating leverage generated from growth in software sales, driven by continuing strength in public cloud revenue.
Business Strategy and Outlook
F5 Networks is a leader in the application delivery controller, or ADC, market, with 50% share. Its products have gained wide recognition among medium and large organizations as well as service providers for the ability to manage and secure network traffic coming in and out of corporate IT departments. Although it is entrenched, its core market will shrink over time.
In a nutshell, F5's hardware and software appliances serve as an intelligent coordinator of network traffic between the outside world and internal data center. These products are very powerful and complex. Because of their enterprise nature, F5 appliances are most commonly used by larger organizations operating with a significant web presence and multiple sites, typically requiring a dedicated engineer.
F5 has been extremely successful at expanding its ecosystem of products and organically expanding the ADC market. It has also consistently entered into adjacent market niches through acquisitions, building up a portfolio of network traffic management and protection solutions that cohesively work with one another.
As a result of product complexities and architectural positioning at the forefront of the typical corporate IT data center, F5 products are very entrenched. With ever-expanding need for remote users to access internal corporate resources, added business requirements for online presence, and an increasing number of data streams flowing in and out of corporate data center, F5 products sit at the epicenter of traffic flow. Given the time and resources required to deploy and customize F5 installations with all the aforementioned traffic requirements in mind, these products are very sticky.
We view F5 as the strongest player in ADC market with good potential to further expand its presence in the security segment. The nascent cloud-based players in this market can’t yet match F5’s sophisticated capabilities. However, in the long term, we see AWS and Azure ADC solutions maturing. This poses a significant threat to F5's position, as these providers will be able to deliver similar capabilities for a fraction of the cost.
F5 Networks' product flexibility and complexity allow enterprises and service providers to deploy fully tolerant, secure, and highly customized solutions. Given the strategic position of F5's products in the corporate networks and complexity of deployment, along with a large body of knowledge available to support F5, IT managers will be highly reluctant to switch to a competing product. F5 has established itself as a leader in the mature application delivery controller field, with 50% market share and considerable brand strength. We consider F5's competitive advantages to be long lasting and assign the firm a narrow moat rating.
F5 Networks' ecosystem of products, the BIG-IP family, is based on its Traffic Management Operating System. BIG-IP is a highly configurable platform that allows various network traffic manipulation (iRules), event-based automation (iCall), and programmatic configuration (iControl). F5 has cultivated a strong community of network engineers and architects at its support platform, DevCentral, which also contains a large collection of prebuilt traffic scripts. Such a high level of flexibility allows enterprises and service providers to deploy a highly customized solution that governs the network traffic at the application level and below. F5 products are an essential part of multisite, web-facing networks. While the deployment of F5 products is not an easy task in the modern IT data center, given a spaghetti of third-party and in-house built apps making numerous inbound and outbound connections among sites and various service providers, we consider this a strategic advantage for F5. Customers are reluctant to embark on a competitive product switchover, owing to the highly disruptive nature and the time and resources required to get this task accomplished.
F5 was an early leader in network load balancing, which later evolved into the ADC marketplace. Over the course of years, the company has steadily incorporated in its platform a number of additional services and functionalities, such as web application firewall, SSL VPN, WAN optimization, threat detection, and DDoS prevention. The company is seen as a market leader and has developed a strong reputation, especially in light of Cisco's exit from this space. This strong competitive advantage allows F5 to charge premium pricing for its products and represents another moat source.
Fair Value and Profit Drivers
We value F5 Networks at $126 per share, which implies adjusted forward price/earnings of approximately 13, enterprise value/adjusted EBITDA of 10, and free cash flow yield of nearly 8%. F5 is a narrow-moat stock with decelerating revenue growth, and it is seeking to expand its presence outside the core ADC market.
F5's revenue composition is shifting rapidly from products to services, with a revenue mix of 46% and 54%, respectively, in fiscal 2017. Approximately 98% of product revenue comes from the application delivery networking segment, with the remaining 2% coming from security. While the ADC market growth is projected to slow and security so far represents a tiny segment of F5 revenue, we expect the services segment to drive top-line growth during our explicit forecast period. Overall, F5 revenue should reach $2.4 billion by 2022, in our opinion.
F5's gross margin displayed healthy improvement over the past few years, expanding from 77% in 2008 to 83.1% in 2017. As IT workloads are increasingly shifting to the cloud, F5 is forced to compete with low-cost, cloud-native ADC solutions, which should have a negative impact on long-term gross margin of the firm, which we project will decline to 82% by 2022. Similarly, management navigated the company from a 16% operating margin in 2008 to an impressive 28% in 2017. Here, too, we expect operating margins to oscillate a bit lower, in the 26.5%-27.5% range.
Overall, in the past five years, F5 has generated solid free cash flow. We expect this trend to continue, given the firm's strong market position and impressive profitability profile. The balance sheet remains healthy, and the company has been returning capital to the shareholders via share buybacks.
Risk and Uncertainty
With Cisco’s exit from the ADC market, F5 solidified its leadership position. While Citrix and Radware remain strong competitors, we do not foresee any drastic market share realignment among these players. The more important factor to consider is the tectonic shift in the industry, with the increasing stream of applications and workloads that are leaving the on-premise data center in favor of cloud computing. F5 offers a virtualized version of its BIG-IP platform for Amazon AWS and Microsoft Azure, which should help to alleviate short-term concerns. However, in the long run, we forecast Amazon and Microsoft cloud-based alternatives to F5's ADCs to be compelling to their customers.
Looking beyond the ongoing transition to the cloud, we expect an increasing number of applications written to run specifically in the cloud, using cloud-based resources and thereby limiting the need for complex traffic orchestration. This type of architectural shift will significantly undermine the need for F5 products.
Overall, we view F5 Networks' stewardship shareholder capital as standard. F5 Networks' success has been associated with longtime CEO John McAdam, who took over the company in 2000. During his tenure, F5 Networks' revenue grew from $108 million to almost $2 billion and the company was added to S&P 500. The company continuously expanded its market space and entered adjacent niches through organic growth and bolt-on acquisitions while successfully fighting its much larger competitors. In fact, the company became the de facto standard for the ADC market. McAdam retired in April 2017. New CEO Francois Locoh-Donou holds a bachelor of science and a master of science in physics and engineering, a master of science in optical communications, and an MBA from Stanford. He left the COO position at optical transport vendor Ciena, where he had been since 2002. We believe Locoh-Donou was the driving force behind Ciena’s Cyan acquisition and the overall push to increase the company’s focus on software solutions, which have become a focal point for many of Ciena’s clients. F5 and Ciena are targeting similar set of customers, which bodes well for Locoh-Donou.
The company has been steadily repurchasing shares while executing focused, tuck-in acquisitions to expand its business. The $2.4 billion stock-repurchase program initially approved in 2010 was supplemented by an additional $1 billion authorization in 2016. The recent acquisitions of Versafe ($87.7 million) and Defense.Net ($49.4 million) are intended to boost F5's efforts to carve out a niche in the security market.
F5 Networks provides products that govern traffic flows between on-premise applications and external users and services. In addition, the company provides numerous security solutions geared toward its existing user base. The company is a recognized market leader in application delivery controller equipment in the U.S. and around the world. The North American market represents approximately 50% of the company's revenue, EMEA 23%, and APAC 15%.